ESG and tax transparency: the next frontier of tax disputes?

The importance of environmental, social and governance (ESG) issues to businesses cannot be underestimated, with investors, lenders, regulators, employees and other stakeholders alike increasingly expecting to understand how ESG fits into a business’ strategy.  But how does tax fit into the ESG landscape?  We explore that topic in further detail here.  As that blog post highlights, an important aspect of ‘G’ from a tax perspective is the shift towards greater transparency in tax matters.  At first blush, that might sound like it’s just a compliance issue – but businesses should be aware of the potential for information reported under these measures to lead to increased tax audits and investigations in the longer term.

The ESG context

Tax transparency is itself a somewhat nebulous concept, but broadly it involves businesses being open and clear about the details of their tax practices and payments.  Depending on the reporting measure in question, this can involve transparency vis-à-vis relevant tax authorities and/or the public at large. 

From an ESG perspective, measures to increase tax transparency are of interest because they are widely seen by governments worldwide as being an important tool to support key tax initiatives that fall under the ‘S’ heading – in particular, those that seek to ensure businesses pay the ‘right’ amount of tax and do so in the ‘right’ jurisdiction. 

The increase in tax transparency measures

There is a vast array of measures – some already in force, others in the process of being enacted – which aim to boost tax transparency.  Some are of near-universal application, others specifically target only large groups or businesses in particular sectors.  A comprehensive list of these is beyond the scope of this blog post, but key measures include:

• Country by country reporting (CbCR) – these rules were proposed as a minimum standard under the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan 13 and have now been implemented in more than 110 jurisdictions (a number which is expected to continue to grow). CbCR requires large multinational groups (ie broadly those with total consolidated group revenue of €750m or more in an accounting period) to file annual returns breaking down on a jurisdiction-by-jurisdiction basis certain key tax and financial information.  Reports are typically filed in the jurisdiction of the parent company and then automatically shared with relevant tax authorities worldwide.
• EU public CbCR – going one step further than the OECD’s CbCR requirements, the EU has introduced a public CbCR regime, under which large multinational groups will be required to publicly disclose such tax and financial information insofar as it relates to operations in EU Member States or ‘non-cooperative jurisdictions’.  The implementation date for transposing the underlying Directive into domestic law has now passed, but in most EU Member States disclosures will only be required in relation to financial years beginning on or after 22 June 2024.
• Disclosure of uncertain tax positions – various jurisdictions worldwide (including Australia, the UK and the US) require certain businesses to proactively notify domestic tax authorities if they adopt an uncertain (ie potentially contentious) position in their tax returns.  In the UK, for example, large groups (ie those with a turnover of more than £200m and/or a group balance sheet of more than £2bn) that do not follow HMRC’s known position when compiling their tax returns or otherwise make a provision for tax uncertainty in their accounts must notify HMRC if their adoption of such tax treatments gives them a potential aggregate ‘tax advantage’ in excess of £5m in a given period.
• Reporting rules for digital platforms: the purpose of these rules is to target perceived tax non-compliance by individuals and other persons who provide services or sell goods via online platforms.  They work by requiring the platforms to provide tax authorities with sufficient information to allow those authorities to run compliance checks on such persons.  This information is then typically automatically exchanged with other tax authorities adopting similar rules.  EU Member States are obliged to implement these rules (contained in the seventh amendment to the EU Directive on Administrative Cooperation in the field of taxation (DAC), so referred to as ‘DAC7’), with first reports due by the end of January 2024.  As these are OECD-mandated model rules, similar rules may apply outside the EU: for example, the UK has introduced similar rules that take effect from January 2024.
• Publication of tax strategies – a number of jurisdictions have implemented, or are in the process of implementing, rules which require certain businesses to publish details of their tax strategy.  In the UK, for example, large businesses (ie those required to file CbCR reports and groups with a turnover of more than £200m and/or a group balance sheet of more than £2bn) are required to make freely available on their website information about how they manage their UK tax risks, their attitude to tax planning, the level of risk they are prepared to accept in UK tax matters and how they work with HMRC, with financial penalties for non-compliance. 

Tax transparency measures are not static and businesses need to be alive to additional tax transparency measures being introduced.  Just last month, the EU Council formally adopted proposals to bring cryptoassets within the scope of existing EU tax reporting and information exchange obligations (referred to as ‘DAC8’).  The proposed EU ‘Unshell’ Directive (discussed further here) may also add to the tax transparency landscape by imposing a notification requirement on EU entities that constitute a ‘shell’ for these purposes, although the timing for agreement on this proposal remains unclear.  

It should also be noted that more general transparency measures may also have a tax aspect.  For example, the EU’s broader sustainability disclosure framework incorporates some tax criteria.  This is currently primarily via the EU Taxonomy Regulation which provides a classification system to help groups and investors identify environmentally sustainable economic activities to make sustainable investment decisions. The EU Taxonomy also contains certain ‘minimum safeguards’ which include requirements for ‘good’ tax governance and compliance.  It is possible that future revisions of the EU Corporate Sustainability Reporting Directive and related reporting standards may put a stronger focus on these tax criteria. 

The possible increase in tax disputes – and what steps businesses can take

There is clear scope for this raft of onerous and evolving tax transparency measures to cause a compliance headache.  And looking further ahead, it seems inevitable that increased tax transparency will lead to more tax disputes.

Disputes about the tax reporting requirements themselves

The increase in tax reporting requirements inevitably means that there are more sets of complex rules for groups to comply with, and there is a risk of disputes arising as a result of groups failing properly to do so. 

Bearing in mind how many such regimes large multinational groups in particular may already be subject to – and how complicated and onerous some of these are – methodical processes and appropriate staffing will be needed to ensure all applicable reports are made in an accurate and timely manner.  In particular, the importance of an adequate review procedure, designed to identify potential inconsistencies between reports made in different jurisdictions, cannot be overstated.

Looking ahead, and noting that the number of reporting requirements is only set to increase over the coming years, businesses should bear in mind that their compliance processes will likely need to be expanded and updated over time.  Monitoring developments in this space on an ongoing basis is therefore important – being ahead of the curve, rather than waiting for a tax authority to raise potential concerns, is always advisable in this context.

Disputes arising from increased tax transparency

The intended result of increased tax transparency is that tax authorities around the globe will have access to more (and more granular) information about large multinational groups.  Going forward, it will consequently be easier for tax authorities to identify issues in a group’s tax affairs which were previously harder for them to spot.  As such, it seems very likely that tax authorities will open more tax audits and investigations into businesses that are required to provide information under these tax transparency regimes. 

There are some nuances here.  There is an argument that increased tax transparency means tax audits and investigations will be more targeted – although that could still result in a higher number of challenges overall.  Further, in some jurisdictions there is the possibility of tax authorities simply becoming overwhelmed by the volume of data available to them – although this may be less of an issue with the increasing range of tech tools available for tax authorities to sift through large quantities of information. 

Overall, though, as explored in our Tax investigations and disputes across borders guide, we expect this to be an international trend in the contentious tax space in the months and years ahead. 

This is borne out by our experience of other tax reporting requirements.  The OECD’s Common Reporting Standard (CRS) is a global standard for the collection and automatic exchange of information related to financial accounts.  Information was first exchanged under the CRS framework in 2017, and in recent years we have seen tax authorities in multiple jurisdictions use the information received as a basis for opening audits.  Even seemingly straightforward requests for additional information can require careful thought – balancing the relationship and reputational benefits of providing the requested information promptly and comprehensively against the cost of, and potential risks inherent in, sharing information without first carefully considering both the validity of the request and what the tax authority may infer from any information disclosed – and can easily spiral into a wider dispute.

Relatedly, because some tax transparency measures also lead to the public having more information about the approach businesses take to managing their tax affairs, there is the possibility of more campaigns and legal challenges on tax matters being brought by activists, lobbyists, shareholders and other third parties. Some of these may, directly or indirectly, lead to businesses becoming embroiled in tax disputes with the potential for related adverse publicity. 

Getting on the front foot here is advisable: if businesses are aware of potential ‘red flags’ in the information they will be reporting, thought should be given as to whether it is preferable to proactively discuss these points with tax authorities ahead of time.   Specialist legal advice is always recommended in such cases.

If you would like to discuss any of the points raised in the guide or this blog post in further detail, please contact the authors, our tax investigations and disputes team or your usual Freshfields contact.